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Housing's Fate Hangs In The Budget Balance

November 05, 1995

Business Outlook: U.S. ECONOMY

HOUSING'S FATE HANGS IN THE BUDGET BALANCE

As you tote up the likely winners and losers in the 1996 federal budget battle, don't forget homebuilders. No, there are no big hits from spending cuts or special tax goodies in the works, but if all goes as planned, lower long-term interest rates could give the housing industry new life next year.

Clearly, the momentum to balance the budget by 2002, er shortly thereafter, is enormous, and the effort is shaping up to be the most credible to date. All this bodes well for lower interest rates, including those for mortgages. Market watchers generally agree that the bond market will embrace the long-run implications of the final budget package. Those include expectations of lower inflation and a gradual decrease in the supply of new Treasury securities hitting the market.

However, the bond market will also keep a sharp eye on the short term. The immediate fiscal drag on the economy from the budget deal is shaping up to be barely, if at all, discernible. And depending on when the tax and spending cuts kick in, the package could even end up slightly stimulative for fiscal 1996--something the bond market would dislike.

To some extent, a deficit-cutting deal is already priced into long-term bond yields, and thus mortgage rates (chart). If the bond market likes the package, yields still appear to have room to dip lower. Ten-year Treasury bonds, the benchmark for fixed mortgage rates, have yielded 2.6%, on average, above current inflation. With inflation now under 3% and likely to remain low, and with the yield on the 10-year bond hovering at 6%, yields below 5.5% seem possible.

CONGRESS AND THE WHITE HOUSE have to get their acts together, though. Votes on both the Senate and House versions of the budget are due shortly, but with the White House expected to veto the resulting reconciliation bill, a final package could be in limbo until December.

Before then, the Treasury will bump up against its $4.9 trillion debt limit, and on Nov. 15 it will need $25 billion in fresh cash to make semiannual interest payments on its debt, not to mention $205 billion to pay off maturing debt and $100 billion or so to run the government. An outright default seems unlikely, but the bond market is watching closely.

Analysts generally agree that when it's all over, the feared "train wreck" is more likely to be a fender-bender. But the path toward deficit reduction will be clear, and therein lies the chance for lower rates.

A FURTHER DECLINE in mortgage rates would come at a good time for homebuilders. This year's lower rates have strengthened housing demand and starts. Sales of existing homes edged up 0.7% in September, to an annual rate of 4.15 million. The increase was the fifth in a row. The gains have been fueled mainly by cheaper mortgages.

The rate on 30-year fixed mortgages fell from 9 1/4% last December to a 20-month low of 7.38% in mid-October, according to the Federal Home Loan Mortgage Corp. That's enough to drop the monthly cost of a $100,000 mortgage from $820 to $690.

But until the bond market sees the final budget package, rates may hold steady. And without further rate declines, housing activity is likely to stabilize in coming months near current levels.

Mortgage applications for home purchase, as opposed to refinancing, are already leveling off. New filings had picked up in September, but by mid-October, they have drifted back to a level slightly below their average of the past three months, according to data from the Mortgage Bankers Assn.

Housing starts have plateaued as well. They edged lower in September, to an annual rate of 1.39 million, after dipping in August. That's a respectable level of activity, but keep in mind that starts are still 4% below their year-ago pace.

Even so, builders seem upbeat about current market conditions. The housing market index of the National Association of Home Builders rose some 7% in October, to 57% (chart). A reading over 50% means that more builders see good conditions than see a poor climate in the areas of present sales, expected demand, and traffic through model homes.

The pickup in demand since spring has helped to clear away excess inventories of unsold homes, so builders are now freer to respond to new demand. However, they remain cautious in the face of prospects for only moderate growth in the economy generally and in employment in particular.

Builders report that speculative building--homes started without a specific buyer--remains at a low ebb, even as borrowing costs have fallen slightly as a result of the July 6 cut in interest rates by the Federal Reserve.

Homebuilders also will continue to face some unfavorable demographics. The population aged 25-34, the prime first-time home-buyer market, has been declining since 1990, and it will keep falling into the next century.

BUT WHILE THE BOND MARKET would be pleased with a long-term stab at deficit reduction, lower long-term interest rates next year are not necessarily in the bag. In an election year, the temptation to bring the tax goodies forward and suffer the painful spending cuts later will be great.

September closed out the 1995 fiscal year. The Treasury delayed its September budget report, originally set for Oct. 23, as usually happens at fiscal yearend, but analysts expect a September surplus of about $8 billion. That would bring the 1995 deficit to about $162 billion, down from $203.3 billion in 1994.

The expected 1995 gap will be the lowest since 1989 and the smallest in relation to gross domestic product since 1979. The 1996 deficit is expected to be a few billion higher, depending on the final budget compromise (chart).

However, the way to look at fiscal restraint or stimulus is the so-called standardized employment deficit as a percentage of potential GDP. In layman's terms, it's the federal deficit adjusted for the swings in the business cycle. Recent estimates by the Congressional Budget Office put the 1995 estimate at 2.7% of GDP.

However, estimates by HSBC Washington Analysis show that, depending on the mix of tax and spending cuts, the 1996 percentage could be anywhere from 2.3%, a modest move toward restrictiveness, to greater than 3%, a slightly stimulative move. Decimal points aside, the analysis suggests little or no fiscal drag from the budget next year.

Compared with conventional wisdom, which says that deficit reduction will start hitting the economy immediately, that lack of fiscal restraint would bode well for economic growth generally next year. As long as the budget in succeeding years cuts the deficit in credible ways, both the bond market and the Federal Reserve appear poised to provide the economy with lower rates. If so, the housing upturn will hang around for at least another year.BY JAMES C. COOPER & KATHLEEN MADIGAN